As a startup founder, you’re constantly looking for ways to grow your business and secure the funding necessary to make your vision a reality. The moment you have tried to raise you will have immediately come across the issuance of preference shares. This blog post will explore what preference shares are, their advantages and disadvantages, and how they can impact your startup’s fundraising journey.
What are Preference Shares?
Preference shares, also known as preferred shares or preferred stock, are a type of equity security that grants the holder certain preferential rights over common shareholders. These rights typically include a priority claim on dividends and assets in the event of liquidation. These are what all venture capital investors expect to invest in when they gift cash to startups to have fun with.
Preference shares explained to a teenager
Alright, imagine you’re starting a cool business, like a new video game company. You have an awesome idea, but you need money to turn your idea into reality. So, you look for people who are willing to invest their money in your company in exchange for a part of the ownership.
Now, there are two main types of ownership shares you can give to your investors: ordinary shares (also called common shares) and preference shares. As a teenager, you might already know about ordinary shares – they give people a small piece of the company and let them have a say in how the company is run.
Preference shares are a bit different. They’re kind of like a special club membership for investors who want extra perks. With preference shares, investors get some extra benefits that ordinary shareholders don’t have. Here are a few examples:
- If your company makes a profit and decides to share that money with the owners, preference shareholders get paid first, before the ordinary shareholders.
- If something goes wrong and your company has to close down or sell, preference shareholders get their money back first, before ordinary shareholders.
- Preference shareholders usually don’t get to vote on company decisions, like who’s on the board of directors, but they might have special powers to stop certain big decisions if they don’t like them.
So, for you as a founder, offering preference shares to investors can help you raise money for your company, because investors like the extra perks they get. But, you also need to be careful because giving away too many preference shares can limit your control over your startup and affect how much money you make when your company becomes super successful.
When were preference shares invented in venture capital investment of startups?
The concept of preference shares has its origins in the history of corporate finance, dating back to the 19th century. Preference shares, as a financial instrument, were designed to provide investors with fixed dividends and a priority claim on a company’s assets in the event of liquidation.
While the use of preference shares in venture capital investments in startups is difficult to pinpoint to an exact date, the modern venture capital industry began to take shape in the mid-20th century. Georges Doriot, who founded American Research and Development Corporation (ARDC) in 1946, is often considered the “father of venture capital.” ARDC was one of the first firms to provide professional funding and management assistance to new and emerging companies. As the venture capital industry evolved, preference shares became a popular tool for investors to structure their investments in startups.
The practice of using preference shares in venture capital investments became more widespread during the late 20th century, especially during the 1980s and 1990s, as the technology sector began to boom. The use of preference shares allowed venture capitalists to manage the risks associated with investing in early-stage companies while providing the capital needed for these startups to grow and innovate.
How do preference shares actually impact you?
If you grow like weeds and have a huge exit, it’s likely that you don’t care about preference shares (unless they are participating preferred).
If you have ‘clean’ preference shares, they just convert into common shares at your exit and you might not even be aware.
Where preference shares can flark you is when they are fancy and you don’t sell for much. In that case you might end up with nothing. Yes, sir. Nada. Zilch.
Why? Check out liquidation preferences.
What are the main types of preference shares?
Preference shares come in various types, each offering different features and benefits to meet the preferences of investors.
This nerd stuff can seem like a lot to understand, but really you can make it simple. The more the ‘prefs’ look like your common shares, the better. The more complicated things get the more you are getting screwed over by investors, either because:
- The investor is an ass-hat trying to f you over
- You messed up big and really need the $ so they are covering their ass taking a big risk giving you anything
Furthermore, whilst I’ve listed 8 kinds of preference shares, only a few are ever really seen in the wild in startup land, and many are for public companies.
Here are the types of preference shares:
- Cumulative Preference Shares: With cumulative preference shares, if a company is unable to pay dividends in a given year due to insufficient profits, the unpaid dividends accumulate and must be paid out before any dividends are distributed to common shareholders. This ensures that preferred shareholders receive their entitled dividends eventually, even if there are temporary financial setbacks.
- Non-Cumulative Preference Shares: Unlike cumulative preference shares, non-cumulative preference shares do not accumulate unpaid dividends. If a company skips a dividend payment, the unpaid dividends are forfeited, and preferred shareholders have no claim on them in the future.
- Participating Preference Shares: Participating preference shareholders not only receive their fixed dividends but also have the opportunity to participate in additional profits. After common shareholders receive a specified dividend, the remaining profits are distributed between common and preferred shareholders on a pro-rata basis, allowing participating preference shareholders to potentially receive higher dividend payments.
- Non-Participating Preference Shares: Non-participating preference shareholders receive only their fixed dividends and do not participate in additional profits or surplus earnings. Their dividend payment is limited to the fixed rate specified in the share agreement.
- Convertible Preference Shares: Convertible preference shares come with a feature that allows preferred shareholders to convert their shares into common shares at a predetermined conversion rate. This offers the potential for capital appreciation if the company’s common share price increases, providing an additional upside for investors.
- Non-Convertible Preference Shares: Non-convertible preference shares do not have the option to convert into common shares. These shares maintain their preference status throughout their existence, providing a fixed dividend and priority in liquidation but without the potential for capital appreciation through conversion.
- Redeemable Preference Shares: Redeemable preference shares are issued with a redemption feature, which allows the company to repurchase the shares at a predetermined price after a specific date or under certain conditions. This provides an exit strategy for investors and can reduce their long-term exposure to the company’s equity.
- Perpetual Preference Shares: Perpetual preference shares have no fixed maturity date or redemption provisions, and they remain outstanding indefinitely. Dividends are paid to perpetual preference shareholders as long as the company is in operation, but there is no obligation for the company to redeem the shares at any point.
That must have felt like a lot, so chill. You will more than likely only ever see very vanilla versions.
Why do founders and staff get common shares and not preference shares?
Founders and staff typically receive common shares instead of preference shares in a VC deal because investors will take what they can get away with. They’ll tell you fancy things to justify it and this might include the following:
- Incentive alignment: Issuing common shares to founders and employees aligns their interests with the long-term growth and success of the company. As common shareholders, their wealth increases as the company’s value grows, incentivizing them to work hard and contribute to the business’s success.
- Risk distribution: Venture capital investors, who usually provide significant capital to a startup, take on a higher financial risk compared to founders and employees. Preference shares offer additional protection to investors, such as liquidation preference and dividend preference, to manage this risk. Founders and employees, on the other hand, are compensated with common shares, which have greater potential upside but do not come with the same level of protection.
- Capital structure simplicity: By issuing common shares to founders and employees and preference shares to investors, startups can maintain a relatively simple capital structure. This clear distinction between the two types of shares simplifies the allocation of ownership and helps avoid potential conflicts related to the distribution of dividends, voting rights, or liquidation proceeds.
- Investors’ expectations: Venture capital investors typically expect to receive preference shares as part of their investment in startups, which come with additional rights and protections that common shares do not provide. As a result, it is a common industry practice for investors to receive preference shares, while founders and staff receive common shares.
- Control and decision-making: Preference shares often come with protective provisions that grant investors veto rights over certain corporate actions. Issuing common shares to founders and staff ensures that they do not have the same level of control over the company’s strategic decisions, allowing investors to have a more significant influence on the business’s direction.
How are preference shares different to common shares?
Preference shares and common shares are both types of equity securities issued by a company, but they differ in terms of the rights and privileges granted to their holders. Here are the key differences between preference shares and common shares:
- Dividend Payments: Preference shares typically have a fixed dividend rate, and preferred shareholders receive dividend payments before common shareholders. This means that in the case of limited profits, preferred shareholders are prioritized, while common shareholders may not receive any dividends. Common share dividends, on the other hand, are usually discretionary and depend on the company’s profitability and board of directors’ decisions.
- Liquidation Preference: In the event of a company’s liquidation, preferred shareholders have a higher claim on the company’s assets than common shareholders. They are usually entitled to receive their initial investment plus any accrued dividends before common shareholders receive any proceeds. Common shareholders are last in line, receiving the remaining assets only after all other claims, including those of preferred shareholders and creditors, have been satisfied.
- Voting Rights: Common shareholders generally have voting rights, allowing them to participate in key corporate decisions, such as electing the board of directors and approving significant corporate actions. In contrast, preferred shareholders typically do not have voting rights, or their rights are limited to specific circumstances, such as when their dividends are in arrears or when certain corporate actions directly affect their shares.
- Convertibility: Some preference shares are issued with a convertibility feature, which allows preferred shareholders to convert their preference shares into common shares at a predetermined conversion rate. This gives them the potential to benefit from the company’s growth and future increases in the common share price. Common shares do not have this convertibility feature.
- Redemption: Preference shares may be issued with a redemption option, allowing the company to buy back the shares at a predetermined price after a specific date or under certain conditions. Common shares usually do not have such a redemption feature.
- Cumulative vs. Non-Cumulative Dividends: Preference shares can be either cumulative or non-cumulative. With cumulative preference shares, any unpaid dividends accumulate and must be paid out before any dividends are distributed to common shareholders. Non-cumulative preference shares do not have this feature; if a dividend payment is skipped, it does not accumulate and is essentially forfeited. Common shares do not have cumulative dividends.
What are the differences between preference shares and ordinary shares?
I’ve set out the key terms in a table.
|Feature||Preference Shares||Ordinary Shares|
|Dividends||Usually have fixed or predetermined dividend rates, paid before dividends to common shareholders||Dividends are discretionary and may not be paid regularly; if paid, they are distributed after preferred dividends|
|Liquidation Preference||Receive priority in the distribution of assets during liquidation, exit, or acquisition||Receive remaining proceeds after preferred shareholders are paid according to their liquidation preference|
|Voting Rights||May have limited or no voting rights depending on the specific terms of the shares||Usually have voting rights on key corporate matters, including the election of the board of directors|
|Conversion Rights||Often have the option to convert preference shares into common shares at a predetermined conversion rate||Cannot be converted into preference shares|
|Anti-dilution Protection||May include anti-dilution provisions that protect investors from dilution in future funding rounds||Usually do not have anti-dilution provisions, and may be diluted during future funding rounds|
|Protective Provisions||May include protective provisions granting investors veto rights over certain corporate actions||Do not typically have protective provisions|
|Preemptive or Pro-rata Rights||May have preemptive or pro-rata rights to maintain their ownership percentage in future funding rounds||Less likely to have preemptive or pro-rata rights|
|Claim to assets||Preference shareholders are paid out first||Common shareholders are paid out last|
Do investors always want to have preference shares?
The short version is yes.
There are times when this may not be the case, or it is not quite explicit:
- Convertible notes: It really depends on the wording, but normally convertible notes convert into the same class of shares as the next funding round, and that’s almost always in preference shares
- Founders have crazy leverage: Think SnapChat, Facebook, Google etc. They can do whatever they want.
- Sneaky founders: If investors are dumb, they might not know legal agreements and the founders do what they want
The thing to know is that preference shares are basically just friends with benefits… meaning shares with stuff you the founders don’t have.
Should founders be worried about giving investors preference shares?
You do not need to be worried about investors having preference shares and you having common. You do not ever get preference shares, and investors almost always expect to get preference shares so there’s just not point in fighting it.
What you need to worry about are the control and economic terms that come with preference shares.
The economic and control rights that venture capital investors typically get
When venture capital (VC) investors invest in a startup, they usually receive economic and control rights to protect their investment and participate in the company’s growth. These rights can vary depending on the negotiation and specific terms of the investment. Some of the typical economic and control rights that VC investors may obtain include:
- Liquidation preference: This right ensures that in the event of a company’s exit or liquidation, preferred shareholders are paid before common shareholders. This helps protect the VC investors’ initial investment and increases their chances of recouping their capital.
- Dividends: Preferred shares may come with dividend rights, providing investors with periodic payments based on a predetermined rate. However, dividends are not common for early-stage startups, as they usually reinvest their profits for growth.
- Anti-dilution protection: This right protects investors from having their ownership diluted in future funding rounds. If the company issues new shares at a lower price than the previous round, the anti-dilution provision adjusts the conversion rate of preferred shares to maintain the investor’s ownership percentage.
- Conversion rights: Investors typically receive convertible preferred shares, which can be converted into common shares at a predetermined conversion rate. This allows investors to benefit from the company’s growth by converting their shares into common stock and participating in the upside.
- Board representation: VC investors often negotiate for board seats or observer rights to have a say in the company’s strategic direction and decision-making process.
- Protective provisions: These provisions grant investors veto rights over certain corporate actions, such as issuing new shares, changing the company’s bylaws, or engaging in significant transactions like mergers and acquisitions. This allows investors to protect their interests and have some control over the company’s major decisions.
- Information rights: Investors may obtain the right to receive regular financial statements, budgets, and other relevant information about the company’s performance. This helps them monitor their investment and make informed decisions.
- Right of first refusal and co-sale rights: The right of first refusal allows investors to have the first opportunity to purchase shares if other shareholders decide to sell their shares. Co-sale rights enable investors to participate in the sale of shares by other shareholders, usually on a pro-rata basis, ensuring they can maintain their ownership percentage.
- Preemptive rights or pro-rata rights: These rights enable investors to maintain their ownership percentage in future funding rounds by participating in those rounds on a pro-rata basis.
Most founders get swept up with the economics of the deal- meaning the headline valuation, but really it’s the control rights that can screw you and this is what founders will refer to as ‘getting clean terms’.
How are preference shares valued differently to common shares in the USA with a 409a?
The short version is that common is typically a third of the valuation of preference shares. I’ll explain why now.
A 409A valuation is an independent appraisal of a private company’s fair market value, which is required by the U.S. Internal Revenue Service (IRS) for compliance with Section 409A of the Internal Revenue Code. This valuation is important for private companies issuing stock options, as it determines the strike price of the options and helps prevent tax penalties for employees. While the 409A valuation primarily focuses on common shares, it may still have implications for preference shares.
Here’s how preference shares are valued differently from common shares in the context of a 409A valuation in the USA:
- Common Shares Valuation: A 409A valuation typically focuses on valuing common shares, as it is used to set the strike price for stock options granted to employees. In this process, various factors, such as the company’s financial performance, growth prospects, risk factors, and comparable transactions, are considered. The valuation of common shares might be lower than that of preference shares, as common shares have a lower priority in liquidation and dividend payments.
- Liquidation Preference: Preference shares often have a liquidation preference, which gives them priority over common shares in the event of the company’s liquidation. When performing a 409A valuation, this liquidation preference is considered and can result in a higher valuation for preference shares compared to common shares. The 409A valuation usually involves discounting the preference shares’ liquidation preference and dividend rights to account for their preferential treatment.
- Control Premium: In the 409A valuation, a control premium might be applied to the common shares, which represents the value of voting rights and the ability to influence company decisions. As preference shares typically have limited or no voting rights, they do not receive this control premium, leading to a difference in valuation compared to common shares.
- Conversion Features: Preference shares may have conversion features that allow them to be converted into common shares at a predetermined rate. This conversion feature can impact the valuation of preference shares. In the 409A valuation, the conversion ratio and the probability of conversion are taken into account to estimate the value of convertible preference shares.
- Risk Profile: The risk profile of preference shares differs from that of common shares due to their priority in dividend payments and liquidation claims. The 409A valuation will consider the differences in risk profiles when valuing preference shares and common shares, which can lead to different valuations.
It is important to note that the primary purpose of a 409A valuation is to determine the fair market value of common shares for stock option grants. While preference shares may be considered in this process, their valuation is not the main focus. However, understanding the differences in valuation for preference shares and common shares can help founders and investors gain a better understanding of the company’s overall capital structure and potential future value.
Why do investors want preference shares?
To keep this blog short(er), why wouldn’t you want to have benefits with friends?
Preference shares confer additional benefits over common. It’s just that simple.
When do venture capital investors not require preference shares in a startup fundraise?
There are situations where venture capital (VC) investors may not require preference shares in a startup fundraise. Some of these scenarios include:
- Early-stage investments: In the case of very early-stage startups or angel investments, VCs might be more willing to invest in common shares, as the primary goal is to support the growth of the company and establish a long-term relationship with the founders.
- Strategic partnerships: When a VC invests in a startup to build a strategic partnership, the focus may be more on collaboration, synergies, and long-term value creation than on obtaining preference shares with specific financial rights.
- Pro-rata investments: When VCs participate in a funding round to maintain their ownership percentage in a company where they have already invested, they might not require preference shares, especially if they already hold a significant amount of preferred stock from previous rounds.Bridge financing: In certain situations, VCs might provide bridge financing to a startup in the form of a short-term loan or convertible note instead of preference shares. This can be a quicker and more flexible way to provide funding without negotiating the terms of a new class of preferred shares.
- Strong founder negotiating position: If a startup’s founders have a strong negotiating position due to high demand from investors, exceptional traction, or unique technology, they may be able to raise capital without offering preference shares, as VCs may be willing to accept common shares to secure an investment in the promising company.
- VC investment philosophy: Some VCs may have an investment philosophy or strategy that prioritizes common shares over preference .shares This could be due to the desire for a more straightforward, founder-friendly investment structure or a belief in the long-term growth potential of the company, which could outweigh the benefits of holding preference shares.
Investors not requiring preference shares is the exception not the rule though!
What rights typically come with preference shares for venture capital investors when investing in a startup?
When venture capital (VC) investors invest in a startup using preference shares, they usually receive certain rights and privileges that provide them with additional protection and control. Some of the typical rights associated with preference shares for VC investors include:
- Liquidation Preference: This right ensures that preferred shareholders receive a specified return on their investment before any distributions are made to common shareholders in the event of a company’s liquidation, sale, or merger. The liquidation preference is typically expressed as a multiple of the original investment (e.g., 1x, 2x).
- Dividend Preference: Preferred shareholders may be entitled to receive dividends before common shareholders. The dividend rate is often fixed and can be cumulative, meaning that any unpaid dividends will accumulate and must be paid out before any dividends are distributed to common shareholders.
- Conversion Rights: VC investors holding convertible preference shares have the right to convert their preferred shares into common shares at a predetermined conversion rate. This allows investors to participate in the company’s growth and potential upside by converting their preference shares into common shares, which may have greater appreciation potential.
- Protective Provisions: These provisions grant preferred shareholders veto rights on specific corporate actions or decisions that could adversely affect their investment, such as issuing new shares, making significant changes to the company’s capital structure, or approving mergers and acquisitions. Protective provisions provide investors with a degree of control over the company’s strategic direction.
- Anti-Dilution Protection: This right protects VC investors from the dilution of their ownership stake in the event that the company issues new shares at a price lower than the price paid by the preferred shareholder. Anti-dilution provisions typically adjust the conversion rate of preference shares to common shares to maintain the investor’s ownership percentage.
- Redemption Rights: Some preference shares grant investors the right to require the company to repurchase their shares at a predetermined price after a specified period or under certain conditions. This provides an exit strategy for investors and reduces their long-term exposure to the company’s equity.
- Pre-emptive Rights: Also known as pro-rata rights, these rights allow VC investors to participate in future funding rounds to maintain their ownership percentage in the company. Pre-emptive rights help investors protect their stake from being diluted by subsequent investments.
- Board Representation: VC investors may negotiate the right to appoint one or more directors to the startup’s board, giving them direct influence over the company’s strategic decisions and corporate governance.
- Drag-along Rights: These rights enable majority shareholders, usually preferred shareholders like VC investors, to force minority shareholders to sell their shares in the event of a company sale or merger, ensuring that the transaction can proceed smoothly.
- Tag-along Rights: Tag-along rights allow minority shareholders, including preferred shareholders, to sell their shares alongside majority shareholders in the event of a company sale or merger, ensuring that they receive the same terms and pricing as the majority shareholders.
These rights provide VC investors with a level of protection, control, and potential upside when investing in startups using preference shares. However, the specific rights and provisions associated with preference shares can vary based on the negotiation between the startup and the investor during the fundraising process.
What happens if investors own preference shares in a startup that goes bankrupt?
If a startup goes bankrupt, its assets are typically liquidated to pay off its debts and obligations. In this scenario, the investors who own preference shares have certain advantages over the common shareholders. Here’s what usually happens:
- Liquidation preference: Preference shares come with a liquidation preference, which determines the order in which proceeds from the liquidation of assets are distributed among shareholders. Preferred shareholders are paid before common shareholders, which increases their chances of recouping at least a portion of their investment.
- Liquidation multiple: The liquidation preference often includes a multiple, which is the amount of money preferred shareholders are entitled to receive before common shareholders get paid. This multiple is typically 1x, meaning that preferred shareholders receive the amount of their initial investment before any proceeds are distributed to common shareholders. In some cases, the multiple could be higher, further prioritizing preferred shareholders.
- Conversion to common shares: In certain situations, preferred shareholders may choose to convert their preference shares into common shares. They might do this if the liquidation proceeds are large enough that owning a larger portion of common shares would yield a higher return than their liquidation preference. However, this option is less likely to be exercised in a bankruptcy scenario, as the company’s assets might not be sufficient to cover all its obligations.
It’s important to note that if a startup goes bankrupt, there’s no guarantee that preferred shareholders will recover their full investment. The amount they receive depends on the value of the company’s assets and the outstanding debts and obligations the company needs to fulfill. If the liquidation proceeds are not enough to cover the liquidation preference of all preferred shareholders, they may only recover a portion of their investment or, in the worst-case scenario, nothing at all.
Overall, while preference shares provide a higher level of protection in a bankruptcy scenario than common shares, investors still face the risk of losing part or all of their investment if the company’s assets are insufficient to cover its debts and obligations.
Preference shares can be a valuable financing tool for startup founders looking to raise capital while maintaining control over their company’s strategic direction. By understanding the advantages, disadvantages, and key considerations surrounding preference shares, you can make informed decisions and optimize your fundraising efforts to support the growth and success of your startup.